RELATIONSHIP BETWEEN RISK AND RETURN

Introduction

Investmentdecisions are influenced by various motives. Some invest in a business to acquire control and thus enjoy the prestige associated therein. Whereas some invest in expensive yatch’s and famous villa’s to display their wealth. Most investors however, are largely guided by the pecuniary motive of earning areturnon their investment. While investors likereturnsthey abhor risk, investment decisions, therefore involve a trade off betweenRiskandReturn. Our tutors atTranstutors.comare expert in finance from years and years, we provide excellentfinance homework help and assignment help

Return

Returnis the primary motivating force that drivesinvestment. It basically represents the reward for undertakinginvestment. Since the game of investing is aboutreturns(after allowing forrisk). measurement of realized (historical)returnsis necessary to assess how well theinvestmentmanager has done. In addition, historicalreturnsare often used as an important input in estimating future (prospective) returns. The return of anInvestmentconsists of two components :-

CurrentReturn– The first component that often comes in mind when one is thinking aboutreturnis the periodic Cash Flow(Income), such as dividend or interest , generated by theinvestment.Currentreturnis measured as the periodic income in relation to the beginning price of theinvestment.

CapitalReturn– The second component ofReturnis reflectedin the pricechange called the capitalreturn- i.e. it is simply the price appreciation or depreciation divided by the beginning price of the Asset. For assets like Equity Stocks, the capitalreturnpredominates.

Thus, the totalreturnfor any security or Asset is defined as :-

TotalReturn= CurrentReturn+ CapitalReturn

The Current canreturncan only be zero or positive whereas the Capitalreturncan also be negative along with Zero and positive. AtTranstutors.comwe have expert team of tutors who provides are available to assist at ourhomework help and assignment helpsection.

Risk

Investment decisions cannot be talked without consideringRiskas ita trade off between the two. Risk refers to the possibility that the actual outcome of an investment will differ from its expected outcome. More specifically, most investors are concerned about the actual outcome being less than the expected outcome. The wider the range of possible outcomes, the greater the risk. Risk emanates from several sources. The three major ones are Business Risk, Interest rate Risk and Market Risk. On the other hand the Modern Portfolio Theory looks at risk from a different perspective. It divides the Total Risk as follows :-

Total Risk = Unique Risk + Market Risk

The Unique risk of a stock represents that portion of its Total risk which stems from Firm specific factors like the development of a new product, a labour strike or the emergence of a new competitor. The unique risk of a stock can be washed away by combining it with other stocks i.e. by creating a diversified portfolio.

The market Risk of a security represents that portion of its risk which is attributable to economy-wide factors like the growth rate of GDP, the level of government spending, money supply, interest rate structure and Inflation Rate, Since these factors affect all firms to a greater or lesser degree, investors cannot avoid the risk arising from them, however diversification of their portfolios may be . Hence it is also referred to as systematic risk or non-diversifiable risk. Please forward all your queries at ourhomework help and assignment help sectionfor proper and timely solution.